Approaching Zero

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AFTER the most eventful and creative six weeks in the history of central banking, a half-point interest rate cut by the Federal Reserve on Wednesday October 29th was almost anti-climactic. Nonetheless, it was an important strike at the deepening recessionary forces surrounding the American economy, and the Fed made it more significant by jettisoning concerns about inflation from the statement accompanying its action.

The Fed also announced new dollar swap lines with four, big emerging-market central banks to help them cope with shortages of dollars that are roiling their financial markets. It is a sign of how the locus of the crisis has shifted from developed to emerging markets, requiring a corresponding shift in policy initiatives.

Within America the financial crisis is showing signs of easing, but the economic crisis is only just starting, as the Fed broadly acknowledged. “The pace of economic activity appears to have slowed markedly,” the Federal Open Market Committee, the central bank’s policy panel, said in lowering the target on the federal funds rate to 1 percent from 1.5 percent. “Moreover, the intensification of financial market turmoil is likely to exert additional restraint.”

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It both noted the staggering scale of the recent policy stimulus — it called its own lending initiatives “extraordinary” — and implied that more is probably on the way by saying that: “Downside risks to growth remain.” That simple sentence was made all the more striking because it was no longer coupled with a reference to the risk of inflation.

Inflation concerns have lingered over the Fed’s actions since the crisis began in August of last year and at times had held it back from even more aggressive action. Its concerns were understandable as long as commodity costs were soaring and in the face of a lower dollar. But commodities have dramatically reversed course and the dollar has rebounded. The new optimism on inflation is due not just to falling energy costs — petrol in America is now $2.64 a gallon, compared with $4.10 in mid-July — but to a weakening economy that some economists think could eventually push unemployment over 8 percent, up from 6.1 percent in September. The Fed now expects inflation to fall “in coming quarters to levels consistent with price stability.” In practical terms, that means to between 1.5 percent and 2 percent. In August inflation was 4.5 percent (using the price index of personal consumption), or 2.2 percent excluding food and energy.

A federal funds rate target of 1 percent is freighted with symbolism. The Fed’s decision to lower the rate to that level and hold it there in 2003-2004 has been regularly blamed for inflating the credit bubble that led to the current crisis. Policymakers did not appear to worry about the similarities: the vote in favour was unanimous. Appropriately so. The crisis may have been brought on by too much risk taking, but animal spirits have since swung dangerously far in the opposite direction. Spreads between the federal funds rate and other short-term rates are astronomically wide, reflecting both the lack of lending capacity by banks whose capital is under pressure, and rising probability of default by borrowers which naturally leads to wider spreads. While a lower federal funds rate will not narrow that spread, it will reduce the actual level of short-term rates and should help at the margin.

How much lower can the federal funds rate go? Certainly at least to 0.5 percent, a level it has not been close to since the 1950s. But beyond that, things get tricky. Ordinarily, the Fed can keep the federal funds rate on target by adding or draining reserves from banks. But its liquidity operations have left banks with billions of excess reserves to lend out, forcing the federal funds rate well below target on most days. The Fed now pays interest on reserve deposits at 35 basis points below the federal funds rate target. So banks will leave reserves at the Fed once the market rate on federal funds falls to that deposit rate, which is the new, de facto target. So that means if the Fed wants to maintain a 35 basis point spread between what it pays on reserves and the federal funds rate target, it might be hard to get the funds rate target much below 0.5 percent.

Even if the Fed did target zero, it might encourage banks just to leave their money at the Fed rather than lend it to each other, causing the federal funds market to dry up. It would also make it hard for money market mutual funds to pay a competitive yield and cover their operating expenses. Money would flow out of them and into government-guaranteed bank deposits, straining bank capital ratios.

For these reasons, before pushing its rate to zero, the Fed might want to consider variants of “quantitative easing”. This means expanding its balance sheet through the purchase of either government bonds or increased loans to the private sector. It has already in effect taken this route through its many liquidity programmes and swap lines with central banks, which have doubled its balance sheet to $1.8 trillion. But it could go much further.

On Wednesday it announced another such step: the creation of new swap lines with Mexico, Brazil, Korea and Singapore of $30 billion each to enable those countries to provide dollar liquidity to their banks. It is unusual though not unprecedented for the Fed to make such arrangements outside of the rich world economies.

Bold as its actions have been, the Fed cannot battle the recession alone. It needs fiscal policy as well, both to recapitalise lenders through the Troubled Asset Relief Programme — both banks and nonbanks, such as insurers — and to stimulate spending directly through increased public spending or tax cuts.